Today's Bond Managers Have New Rules to Learn as Rate Outlook Shifts

In Tom Wolfe's iconic 1987 novel Bonfire of the
Vanities, Master of the Universe Sherman McCoy isn't a
stock picker; he's a very wealthy bond trader. Like McCoy,
asset managers that have focused on fixed-income investing have
gotten very rich over the last three decades as interest rates
have steadily fallen.

But things are about to get a lot harder for these asset
managers. After an unprecedented five years of loose monetary
policy in the U.S. and around the world that has pushed
interest rates to historic lows, the returns investors can
expect from fixed-income investments have changed dramatically.
In May and June, investors got a taste of the damage that
rising rates can do to bonds, whose prices fall as rates rise.
In May, when Federal Reserve Board Chairman Ben Bernanke first
hinted that the Fed could reduce its bond-buying program as
early as this fall, prices of bonds tumbled; they fell again in
June when Bernanke reiterated those comments rather than
walking them back, as many in the market had been expecting.
According to Cambridge, Massachusettsbased EPFR Global,
which tracks individual and institutional fund flows, investors
yanked $57.8 billion from global bond funds in the four weeks
ending June 28. The largest mutual fund, Pacific Investment
Management Co.'s Pimco Total Return fund, managed by Bill
Gross, had $9.9 billion in outflows in June, after posting a
negative return of 2.65 percent for the month.

The asset management industry has made a killing overseeing
bond funds because of both a rise in the value of these assets
as well as the scale efficiencies in managing bonds. In 2012,
according to the Washington, D.C.based Investment Company
Institute, a trade group for mutual funds, investors put $304
billion into U.S. bond funds, up from $125 billion the year
before. In 2009, bond funds saw a record $380 billion in net
inflows. Global revenue from 2000 to 2012 for fixed-income
managers grew 109 percent versus equity managers' growth of 73
percent in the same period. Among the top 10 firms on the
II300, Institutional Investor's annual ranking of the
300 largest U.S. money managers, are such fixed-income
behemoths as BlackRock, Pimco and Prudential Financial.

Now all fixed-income managers need to change their
investment process, and that won't be easy, according to a new
report from Casey Quirk & Associates, a Darien,
Connecticutbased consultant for investment managers.
Yariv Itah, a partner at Casey Quirk, says he expected that
when rates rose, investors would dump their fixed-income
investments. But his research showed something different
happening. Even before rates started rising in May, investors
were starting to move away from core investments into different
types of bond strategies. "Among retail and institutional
investors, there's not much appetite to decrease their overall
allocation to fixed income. But there is a huge shift into
other types of debt investments than they are in now," says
Itah. Casey Quirk expects that as investors face uncertain bond
markets they will shift $1 trillion of assets  about 15
percent of their portfolios  away from traditional
fixed-income areas such as core, core plus, government bond and
benchmark-oriented strategies tied to popular indices. Those
funds will be directed toward what Itah calls next-generation
debt investments, including global bonds, emerging market
bonds, high-yield and bank loan investments, structured
products and portfolios managed to protect investors' principal
against the ravages of inflation.

There will be winners in the new landscape. Managers who can
manage portfolios opportunistically and find returns from
multiple sources will be in high demand. Itah expects revenue
from these strategies to rise 60 percent by 2017, at which
point they will represent 80 percent of the annual revenue from
U.S. fixed income investors.

Winners in the new era of fixed income are often those whose
investment strategies can't be easily categorized. William
Eigen, who manages $30 billion in an absolute return,
fixed-income strategy for J.P. Morgan Asset Management called
the Strategic Income Opportunities Fund, says people thought he
was crazy five years ago when he started talking about the need
to decouple fixed-income portfolios from popular indices. The
goal of Eigen's strategy is to beat the risk-free rate,
typically U.S. Treasury yields, by a margin of two to eight
percentage points a year, on average, regardless of the level
of interest rates or spreads. But Eigen's fund doesn't fit
neatly into a style box based on duration or credit
quality.

"If some people don't like our process, it's because it's
non-conventional," says Eigen, who headed Highbridge Capital
Management's fixed-income group until he joined JPMAM in 2008.
"If all you do is vary your investments based on various forms
of spread product or interest-rate-sensitive product, then
guess what? You will be vulnerable to those two factors all the
time," says Eigen, who is based in Boston. "So if interest
rates go the wrong way or risk premiums go the wrong way, then
you'll lose your investors a lot of money." In 2008, the fund's
performance was positive, even though most bond funds had
negative returns, some losing as much as 30 percent. In 2011,
the fund had flat performance, while some other funds were up
significantly because they had bet that rates would move from
record lows to even lower record lows.

J.P. Morgan's Strategic Income Opportunities Fund has three
separate portfolios: Opportunistic beta, which invests in
sectors such as high yield and emerging markets; alpha, which
includes synthetics, correlation trades and relative value; and
a hedged portion that can include taking short positions. Since
the launch of the fund, as well as an offshore version,
performance has been negatively correlated to the Barclays
Aggregate bond index.

Jeffrey Gundlach, CEO and CIO of Los Angelesbased
DoubleLine Capital, which has amassed $60 billion in largely
fixed-income assets since its debut in 2009, was a pioneer in
getting away from benchmarks and actively moving money among
different bond asset classes depending on market outlook.
Benchmark hugging "is the wrong way to look at fixed income,"
says Gregory Uythoven, director of marketing at DoubleLine, who
has a background in quantitative analysis and sits on
DoubleLine's fixed-income asset allocation committee.
"Inherently it's flawed. You own the largest issuers and,
unlike in an equity index, the largest issuers in debt are the
ones with largest amount of debt. Then in a crisis, those guys
are compromised."

Uythoven says closed-end funds are another way to manage
unconstrained fixed-income portfolios because they are a
permanent capital pool, can use leverage and do short selling.
In April, DoubleLine raised $2.3 billion for a closed-end best
ideas fund called Income Solutions, which can invest in
everything from emerging market debt to high-yield bonds to
bank loans. But Uythoven stresses that these type of funds
require a lot of labor, analyzing sectors and individual
issues. "It's not like the old core-plus fixed income where you
just sector allocate based on macro views," he adds. DoubleLine
also opened a floating-rate strategy to the public on July
1.

Casey Quirk's Itah says this next generation of debt
investments will blur the line between active management and
alternatives. Traditional asset managers should expect a
significant amount of competition from alternatives firms in
developing products that dump benchmarks, invest across the
capital structure, use derivatives, shift to dynamic risk
management and even invest money directly in deals.

Nick Gartside, JPMAM's London-based international chief
investment officer for fixed income, echoes this view. "We're
transitioning away from a time when fixed-income investors had
the luxury of thinking only in one dimension. Now they need to
think in multiple dimensions," including different geographies,
sectors and currencies.

The new world of fixed income will require big changes on
the part of asset managers, including bond giants like Pimco,
TIAA-CREF and the Vanguard Group. Rick Rieder, BlackRock's
chief investment officer of fundamental fixed income and
co-head of Americas fixed income, says, "We are reaching an
inflection point where people are thinking about managing fixed
income differently." He adds that BlackRock investors are
expressing interest in diversifying their core fixed-income
portfolios. BlackRock's Strategic Income Opportunities Fund,
which like the similarly named J.P.Morgan fund has the
flexibility to invest in everything from government bonds to
high yield to macro and absolute return strategies, has seen
significant inflows over the past two to three months. Rieder
emphasizes, however, "This is not going to be a rotation out of
core and into tactical unconstrained strategies, but rather a
move toward diversification."

Not everyone is ditching benchmarks for an unconstrained
approach to fixed income, though. Insurance companies and
pension funds are just two examples of investors that will want
to continue to use benchmark-oriented strategies for reasons
such as matching assets to long dated liabilities, managers
say. Even in BlackRock's traditional core fixed income, the
firm is being tactical, keeping its interest rate exposure
lower than the benchmark would suggest.

Michael Gitlin, head of fixed income at Baltimore,
Marylandbased T. Rowe Price, says clients will
increasingly want more customization, including global
multi-sector strategies and funds that offer protection against
rising interest rates and inflation. But he is skeptical of
claims that investors will rapidly shift 15 percent of their
allocations from traditional fixed-income areas to so-called
next generation investments. "There will be plenty of people
who want benchmark-oriented strategies even if the benchmark is
dominated by Treasuries, agencies, mortgages and
investment-grade credit that is lower yielding," says Gitlin.
He explains that many investors will want to use part of their
fixed-income allocation as an alpha generator, while others
will use bonds and credit for traditional reasons like
principal preservation, reasonable income and liquidity.

An allocation to international bonds exposes Target Retirement Fund investors to an asset class thats not only influenced by different interest rate and inflation dynamics than U.S. bonds, but which also provides a larger opportunity set of credits.